State Ex Rel. Utilities Commission v. Duke Power Co.

LAKE, Justice. The steps to be taken by the Utilities Commission in fixing rates to be charged by any public utility for its services are set forth in G.S. 62-133 (b), which provides: “(b) In fixing such rates, the Commission shall: *387 “ (1) Ascertain the fair value of the public utility’s property used and useful in providing the service rendered to the public within this State, considering the reasonable original cost of the property less that portion of the cost which has been consumed by previous use recovered by depreciation expense, the replacement cost of the property, and any other factors relevant to the present fair value of the property. Replacement cost may be determined by trending such reasonable depreciated cost to current cost levels, or by any other reasonable method. “(2) Estimate such public utility’s revenue under the present and proposed rates. “(3) Ascertain such public utility’s reasonable operating expenses, including actual investment currently consumed through reasonable actual depreciation. “(4) Fix such rate of return on the fair value of the property as will enable the public utility by sound management to produce a fair profit for its stockholders, considering changing economic conditions and other factors, as they then exist, to maintain its facilities and services in accordance with the reasonable requirements of its customers in the territory covered by its franchise, and to compete in the market for capital funds on terms which are reasonable and which are fair to its customers and to its existing investors. “(5) Fix such rates to be charged by the public utility as will earn in addition to reasonable operating expenses ascertained pursuant to paragraph (3) of this subsection the rate of return fixed pursuant to paragraph (4) on the fair value of the public utility’s property ascertained pursuant to paragraph (1).” Thus, the legislative mandate is that the Commission shall fix rates which will enable a well managed utility to earn a “fair rate of return” on the “fair value” of its properties “used and useful” in rendering its service. These factors are to be determined as of the end of the test period. G.S. 62-133 (c). This concept of a “fair return on fair value” originated as a constitutional limitation over 75 years ago in Smyth v. Ames, 169 U.S. 466, 18 S.Ct. 418, 42 L.Ed. 819. That is, it began as a state *388 ment of the minimum below which the Legislature might not go in fixing public utility rates. Immediately thereafter, the Legislature incorporated this standard into the original version of G.S. 62-133 (b). With relatively minor amendments, insofar as the present appeal is concerned, the original standard has survived and appears in the present statute. The origin of this statute supports the inference that the Legislature intended for the Commission to fix rates as low as may be reasonably consistent with the requirements of the Due Process Clause of the Fourteenth Amendment to the Constitution of the United States, those of the State Constitution, Art. I, § 19, being the same in this respect. After some forty years of struggling, with indifferent success, to give clear meaning to the concept of “a fair return on the fair value,” the Supreme Court of the United States abandoned it as a test of due process of law in public utility rate making. Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591, 600-605, 64 S.Ct. 281, 88 L.Ed. 333. Nevertheless, by virtue of the above statute, it remains as the standard to be applied by the Commission in fixing rates and by this Court in determining appeals from the Commission's order. In Utilities Commission v. State and Utilities Commission v. Telegraph Co., 239 N.C. 333, 344, 80 S.E. 2d 133, Justice Barn-hill, later Chief Justice, said, “This statute has been characterized as an ‘old, rambling, and misty statutory declaration of the matters to be taken into account by the Commission * * * . ’ 12 N. C. Law Review 298.” Since that time it has frequently been characterized in somewhat less complimentary terms. However, as Justice Barnhill there said, “Be that as it may, it is the law in this State and will continue to be the law until amended, revised, or repealed by the Legislature.” Duke contends that, in its order now before us, the Commission did not comply with the mandate of subparagraph (1) of this statute in fixing the fair value of its properties used and useful in rendering electric power service to the public in North Carolina in that its finding of “fair value” is not supported by substantial evidence. It must be so supported. G.S. 62-65. We turn first to this contention. Preliminarily, the Commission found that the reasonable original cost, depreciated, of the properties, as of the end of the test period, was $865,006,125, that the “replacement cost” was *389 $1,199,093,357, that the proper allowance for working capital was $62,416,389. Duke does not challenge these preliminary findings. The finding as to “replacement cost” was derived by the Commission from the testimony of Duke’s expert witness, Mr. Gillett, by applying to his trended cost calculations, computed on the basis of all of the company’s properties, including those in South Carolina, the allocation factors set forth in evidence introduced by witnesses for the Commission staff. The appropriateness of the allocation factors is not questioned by Duke. Thus, Duke does not question the correctness of a Commission’s preliminary finding as to the “replacement cost” of the properties used by Duke in retail service to the people of North Carolina. Having made these preliminary findings, the Commission then found, or concluded, that the “fair value” of the properties allocated to North Carolina should be derived by giving five-sevenths (71.4%) weighting to original cost (i.e., net investment) and two-sevenths (28.6%) weighting to replacement cost. So doing, and adding to the result the working capital allowance which it had found proper, the Commission found the fair value of the properties (was $1,022,876,009). This figure, called the “rate base,” is the amount on which the Commission then undertook to allow Duke to earn a fair return. Duke contends that there is in the record no evidence to support the Commission’s finding of the “rate base” because there is no evidence in the record to support the Commission’s selection of the two weighting factors, five-sevenths and two-sevenths, respectively. Our careful study of this voluminous record, and of the well prepared brief filed by Duke, discloses no expert testimony whatever as to the weight which should be given by the Commission to original cost and to replacement cost in carrying out the statutory mandate to “consider” these indicators of “fair value.” If such evidence be necessary in order to enable the Commission to give appropriate weight to those two indicators, which we think is clearly not the meaning of the statute, the absence of such evidence in the record does not benefit Duke, for the burden is upon Duke to establish the reasonableness of the rate increases it has proposed. G.S. 62-75; G.S. 62-134 (c) ; Utilities Commission v. Railway Co., 267 N.C. 317, 148 S.E. 2d 210. It is the clear intent of G.S. 62-133 (b) (1) that the Commission, in “considering” the indicators of “fair value” which, *390 themselves, are supported by competent and substantial evidence, shall use its own expert judgment as to the credibility of the evidence in the record and as to the weight to be given to it. Utilities Commission v. Telephone Co., 281 N.C. 318, 358, 360, 189 S.E. 2d 705; Utilities Commission v. Telephone Co., 266 N.C. 450, 454, 146 S.E. 2d 487; Utilities Commission v. Public Service Co., 257 N.C. 233, 237, 125 S.E. 2d 457; Utilities Commission v. State and Utilities Commission v. Telegraph Co., supra, at pp. 344, 349. While the Commission may not brush one of the prescribed indicators aside by giving it “minimal consideration,” Utilities Commission v. Gas Co., 254 N.C. 536, 119 S.E. 2d 469, it has not so treated its finding of “replacement cost” in this instance, having given that indicator a weighting of 28.6 per cent, thereby placing “fair value” at approximately $95,500,000 above original cost, depreciated. An addition of over $95,000,000 to the rate base is not “minimal.” A reviewing court may not properly disturb an order of the Commission merely because it would have given a different weight to each of the indicators of “fair value.” Utilities Commission v. Telephone Co., 281 N.C. 318, 339, 360, 189 S.E. 2d 705; Utilities Commission v. Gas Co., 254 N.C. 536, 550, 119 S.E. 2d 469. It is the prerogative of the Commission to determine the credibility of evidence before it, even though such evidence be uncontradicted by another witness. Utilities Commission v. Telephone Co., 281 N.C. 318, 360, 189 S.E. 2d 705. Obviously, it is not the meaning of G.S. 62-133 (b) (1) that, in the absence of expert opinion testimony as to the weight to be given the respective indicators of “fair value,” the Commission must give them equal weight and find “fair value” by the mere striking of an arithmetic average of the indicators. Utilities Commission v. Telephone Co., 281 N.C. 318, 358, 189 S.E. 2d 705. As the Supreme Court of the United States said in R. R. Commission of California v. Pacific Gas & Electric Co., 302 U.S. 388, 397, 58 S.Ct. 334, 82 L.Ed. 319, while it was still struggling with the rule of Smyth v. Ames, supra: “The Commission was entitled to weigh the evidence introduced, whether relating to reproduction cost or to other matters. The Commission was entitled to determine the probative force of respondent’s estimates.” Furthermore, we find in the evidence presented to the Commission by Duke, itself, ample support for a discounting of *391 “replacement cost” as an indicator of fair value. Estimates of replacement cost are inherently speculative to a considerable degree. Furthermore, there is abundant evidence in the record, introduced by Duke, to the effect that its many generating plants, which are the bulk, cost-wise, of its plant in service, are different in efficiency. With justifiable pride, Duke points to its Marshall steam plant as the most efficient such plant in the entire electric power industry. Its other fossil fuel burning generating plants are of varying lesser degrees of efficiency. Its older hydroelectric plants are, according to its evidence, used primarily to meet demand peaks. While the record indicates some present misgivings by Duke as to the savings in operating costs to be effected by its presently proposed nuclear generating plants, the company’s decision to turn for the future completely to nuclear generation, notwithstanding its far greater capital cost, rather than to duplicates of the Marshall plant, hardly supports Duke’s position that the record contains no evidence of substantial obsolescence in its existing plant. Duke’s expert witness on “replacement cost,” the only witness on this subject, testified that he arrived at his figure for this indicator of “fair value,” which figure was accepted by the Commission, by trending the original cost of construction of the present properties, using modern methods of construction, but not varying the design of the present system. Specifically, Mr. Gillett testified: “When I said earlier that I used the present state of the art, I am talking about the art of construction. I didn’t attempt to design an entire plant on today’s state of the art for constructing and operating electric systems designing where the generation would go and what type of generation it would be and how the transmission lines would be laid out and where the substation would be. That would be substitute plant approach, which is a hypothetical situation we didn’t indulge in. “When I say I used the present state [of the] art you are talking about what a building contractor would go do if he were building it today. Present construction techniques, same design and everything, same original investment trended as if it were built with modern materials and construction equipment and labor. * * * “I know the Company is going to a long-range program of 100 percent nuclear on new construction and 1 know that *392 will have the effect of phasing out steam plant but they don’t have one operating yet.” (Emphasis added.) Quite obviously, the present “fair value” of a utility system of generating plants, transmission lines and distribution lines cannot exceed the present cost of constructing a substitute system of modern design, capable of generating and distributing the same quantity of power at less operating expense. See: Justices BrandEis, Holmes and Stone, dissenting, in St. Louis and O’Fallon Railway v. United States, 279 U.S. 461, 488, 517, 49 S.Ct. 384, 73 L.Ed. 798. We find no merit in Duke’s contention that the Commission committed an error of law in its respective weightings of original cost, depreciated, and replacement cost in determining Duke’s rate base. We now turn to Duke’s contention that the Commission erred in fixing the fair rate of return Duke should be permitted to earn upon the rate base so determined by the Commission. Here, too, the Commission and this Court are bound by the provisions of G.S. 62-133 (b). The concept therein contained of a fair rate of return on the fair value of the properties used in rendering the service clearly contemplates the allowance of a greater dollar return than would be allowed if the rate base were the original cost, depreciated, of the same properties, assuming, as is here true, that the value of the properties has been enhanced by inflation. Otherwise, the exceedingly costly and laborious determination of “fair value,” as distinguished from original cost, depreciated, would be a meaningless exercise. It is not for the Commission, or for this Court, to evade the mandate of the statute by determining the number of dollars which would be a fair return on the original cost, depreciated, and then simply translating that amount into a percentage of “fair value.” The formula of the statutory mandate is: A x B = C (fair rate of return multiplied by the fair value of the properties equals the fair return in dollars). Obviously, if A and B are varied in exactly inverse proportion, C remains constant (i.e., if A x B = C, then one-third of A x 3B also equals C). Duke contends that the Commission first determined the dollar return Duke needs, and should be permitted to earn, by multiplying the original cost, depreciated, by what the Commis-son deemed a fair rate of return thereon. Then, says Duke, the Commission increased the rate base to “fair value,” but compensated therefor by decreasing the allowable rate of return in the *393 exact proportion that it had increased the rate base. To do so would be an error of law, for it would, in effect, obliterate the excess of “fair value” over original cost, depreciated. In Utilities Commission v. Telephone Co., 281 N.C. 318, 340, 189 S.E. 2d 705, we said: “The excess of ‘fair value,’ so ascertained by the Commission, over and above the original cost, less depreciation, is an unrealized paper profit to the utility. * * * Nevertheless, G.S. 62-133 clearly contemplates that this excess shall be included in the rate base of the utility, just as if it were a realized profit invested in additional property used and useful in rendering service to the public. * * * [I]t should be treated by the Commission in a proceeding to fix rates as if it were an addition to the equity component of the utility’s capital structure.” Since the decision of the Supreme Court of the United States in Bluefield Water Works & Improvement Co. v. Public Service Commission, 262 U.S. 679, 43 S.Ct. 675, 67 L.Ed. 1176, it has been accepted that a “fair rate of return” is one sufficient to enable the utility to attract, on reasonable terms, capital necessary to enable it to render adequate service. This is the test laid down by G.S. 62-133 (b) (4). We do not have before us on this appeal any question as to whether Duke needs to attract the enormous amounts of capital, which its officers testified must be attracted for expansion of its plant to meet anticipated demands for electric service. The Commission concluded that the maintenance of Duke’s ability to render adequate service does not require the construction of reserve generating capacity as large as that proposed by Duke. In this Court, Duke does not assert any error in this conclusion. The issuance of securities by a public utility in this State is subject to the approval of the Commission. G.S. 62-161. A utility must commence presently to build plant additions which will be needed for adequate service by the end of the time required for construction. However, a utility may not justify an increase in its rates for service to its present customers by evidence of its present intent to build additions to its plant not reasonably considered necessary for adequate service, including proper reserve capacity, by the end of the time needed for the completion of such additions. *394 Likewise, we do not have before us on this appeal any question as to the reasonableness of Duke’s expenditures for salaries and other operating expenses to which reference was made in the separate opinion of Commissioner Wells. No deduction was made by the Commission from Duke’s actual expenditures on this account. Only reasonable expenditures for operating the plant may be charged to the customers. Obviously, rates may not be increased because a utility’s board of directors has paid, or proposes to pay, excessive consultant fees to former officers of the company, whether this be due to bad judgment or to a desire to reward the recipient for services previously rendered to stockholders. Such a bonus must be at the expense of the grateful stockholders, not the ratepayers. Again, this appeal presents for decision no question as to whether Duke’s several rate schedules are so designed as to prefer, unduly, one or more classes of customers over others, through failure to charge the favored class the full cost of supplying its demand for service, and so contribute to the attrition of Duke’s rate of return as the demand by the favored class increases and requires additions to the plant. The sole question presented by this contention of Duke is whether the Commission failed to give heed to our decision in Utilities Commission v. Telephone Co., 281 N.C. 318, 189 S.E. 2d 705, concerning the allowance of a fair return upon the “fair value” increment to the rate base. As we interpret the opinion of the Commission concerning its determination of the fair rate of return, we conclude there is merit in this contention by Duke. The “fair value” increment (fair value of the plant less original cost, depreciated) found by the Commission was approximately $95,500,000. For rate of return purposes, this increment must be added to the equity component of Duke’s actual investment in its electric plant. Duke is entitled, under G.S. 62-133 (b), to earn the same rate of return on this increment as it is entitled to earn on the retained earnings (surplus) which it has reinvested in its plant. The wisdom of this statute is not for us or for the Commission. The Legislature has so decreed and its mandate must be observed by the Commission. Utilities Commission v. Telephone Co., 281 N.C. 318, 340, 189 S.E. 2d 705. In the present case, the Commission found that the cost to Duke of common equity capital (i.e., the fair rate of return *395 thereon) was 11 per cent. The testimony of Dr. Olson, the Attorney General’s witness, supports this finding. So does Duke’s demonstrated ability to attract huge quantities of capital, both debt and equity, when its earned return on equity capital has been less than 11 per cent. See: Lindheimer v. Illinois Bell Telephone Co., 292 U.S. 151, 163-164, 54 S.Ct. 658, 78 L.Ed. 1182. As noted in Duke’s brief and in the dissenting opinion of Chairman Wooten, in two preceding rate cases the Commission had found 12 per cent on the common equity component was a fair rate of return for Duke. Such previous findings are not, however, res judicata, even as to what was a fair rate of return on common equity capital as of the dates of those former orders, and such findings do not prevent the Commission from finding a lower return on common equity capital fair in the present case, even though the tide of inflation has continued to rise. “The fixing of a rate of return shall not bar the fixing of a different rate of return in a subsequent proceeding.” G.S. 62-133 (e). Thus, if the Commission is now of the opinion that in the earlier case it fixed too high a rate of return, it is not thereby precluded from finding a lower rate of return to be fair in the present case. In the present case, having concluded that a fair rate of return to Duke upon its equity component is 11 per cent, the Commission apparently multiplied the equity component of Duke’s actual capital structure (i.e., its common equity capital plus its retained earnings) by 11 per cent and determined that the return of $31,309,147 was a fair return thereon. Adding this to the amount required to pay interest on the debt component and dividends on the preferred stock component of Duke’s actual capital structure, the Commission computed that $72,023,404 was a fair dollar return to Duke on its entire actual capital invested in its electric power system. The Commission then made the mathematically correct computation that the return of $31,309,147 is a return of 8.24 per cent on the common equity component of the actual capital structure plus the fair value increment. When taken in conjunction with the interest requirement on debt capital and the dividend requirement on preferred stock capital, this equated to a return of 7.05 per cent on the fair value of the properties, which return the Commission found to be fair. Obviously, in this computation, the total dollar return which Duke is to be permitted to earn has not been increased at all by reason of the fair value increment. It is exactly the same as the Commission would have allowed if the fair value of the *396 properties had been exactly the same as Duke’s actual net investment in the properties. This is not in accord with the mandate of G.S. 62-133 (b), as construed by us in Utilities Commission v. Telephone Co., 281 N.C. 318, 189 S.E. 2d 705, and, consequently, this proceeding must be remanded to the Commission for compliance with that mandate. This is not to say that the Commission must now revise its order so as to permit Duke to make an additional increase of its rates sufficient to yield additional net income equal to 11 per cent of the fair value increment. It is for the Commission, not for this Court, to determine what is a fair rate of return. It is evident that in the present case the Commission determined that the fair rate, of return on the fair value of Duke’s properties was 7.05 per cent through a misunderstanding of our decision in Utilities Commission v. Telephone Co., 281 N.C. 318, 189 S.E. 2d 705. As we there said, the capital structure of the company is a major factor in the determination of what is a fair rate of return for the company upon its properties. There are, at least, two reasons why the addition of the fair value increment to the actual capital structure of the company tends to reduce the fair rate of return as computed on the actual capital structure. First, treating this increment as if it were an actual addition to the equity capital of the company, as we have held G.S. 62-133 (b) requires, enlarges the equity component in relation to the debt component so that the risk of the investor in common stock is reduced. Second, the assurance that, year by year, in times of inflation, the fair value of the existing properties will rise, and the resulting increment will be added to the rate base so as to increase earnings allowable in the future, gives to the investor in the company’s common stock an assurance of growth of dollar earnings per share, over and above the growth incident to the reinvestment in the business of the company’s actual retained earnings. As indicated by the testimony of all of the expert witnesses, who testified in this case on the question of fair rate of return, this expectation of growth in earnings is an important part of their computations of the present cost of capital to the company. When these matters are properly taken into account, the Commission may, in its own expert judgment, find that a fair rate of return on equity capital in a fair value state, such as North Carolina, is presently less than 11 per cent. This is for the Commission, not for this Court, to determine. *397 As we observed in Utilities Commission v. Telephone Co., 381 N.C. 318, 372, 189 S.E. 2d 705, since a witness cannot, prior to the Commission’s determination of the fair value increment, know the exact capital structure of the utility, for rate making purposes, the witness ordinarily computes the cost of capital (i.e., the fair rate of return) on the basis of the company’s actual capital structure. His computation of the cost of capital must be adjusted by the Commission in order to take into account the effect of the fair value increment on the fair rate of return. If the Commission now holds a further hearing of Duke’s application involved in this appeal, such witness would then know the fair value increment, which has now been determined, and could testify as to the effect, which, in his opinion, such increment would have on the cost of capital. In the ordinary rate case, where the fair value increment has not been determined at the time the witness is testifying, the witness may nevertheless be asked to give his opinion as to the probable effect upon the cost of capital of various hypothetical fair value determinations. This procedure the Commission may see fit to use in future rate cases. The judgment of the Court of Appeals is, therefore, reversed and this matter is remanded to that court with direction that it enter its judgment further remanding the matter to the Utilities Commission for further proceedings by the Commission not inconsistent with this opinion. Reversed and remanded.